Is it the onset of a recession or the fear of a recession that causes a crash? That is what SocGen's bear (or, as he calls himself this time, wolf) Albert Edwards contemplated on the 30th anniversary of Black Monday, before reaching the conclusion that it's the latter. Having taken several weeks off from publishing his ill-named global strategy "weekly" report to meet with clients, Edwards finds that most clients "seem to harbour similar fears as I, namely that the QE-driven bubble will burst at some stage and lay low the global economy, just as it did in 2007." Yet where clients differ, is on the timing of said burst:
"despite my bearish (or is it wolfish) howling, virtually no clients think the denouement will come any time soon and that the equity bull market should have at least 12-18 months left to run. Most can see nothing on the immediate horizon that might burst this bubble."
So, doing his public service to boost the overall sense of dread, and perhaps fear, Albert takes it upon himself to reprise recent discussions with clients, and in his latest letter explains "what might catch them out in the near term." To do this, Edwards focuses first and foremost on the catalysts behind the abovementioned 1987 "Black Monday" crash.
A retrospective macro-narrative was inevitably wrapped around the ?Black Monday? 19 October 1987 equity market crash. My 30-year recollection is pretty good: 1987 saw a buoyant equity market rising briskly through most of the year as the oil price recovered from the previous year?s collapse (from $30 to $8, see chart below). After a year in the doldrums the US economy started to accelerate notably through 1987 as the impact of 1986 interest rate cuts and a lower dollar worked. By the time of the Oct crash the US ISM had surged from 50 at the start of the year to over 60 - a level seldom ever reached (see chart below). Amazingly the ISM has just last month exceeded 60.0 for only the second time since 1987. Spooky!
While one may disagree on the causes, Edwards makes one thing very clear: to hime it was all painfully memorable, and he recalls events from 30 years ago "as if it were yesterday (actually I can?t remember yesterday.)" And whether it was the fear of a recession, or something else, once the selling started, it wouldn't stop until a fifth of market values were wiped out.
Of course the machines took over the selling in the form of Portfolio Insurance programmes, but speaking to my colleague Andrew Lapthorne, he reminds me we also have similarly pro-cyclical ?doomsday? vehicles today - with so much money being run by volatility targeting, risk parity and CTA/trend following quant funds. A fascinating article by stockmarket guru Robert Shiller in a NY Times article to mark the 30th anniversary of the crash, suggests that it was not the Portfolio Insurance that was responsible for the crash, as most official post-mortems suggested, but fear passed by word of mouth. Shiller thinks, in the internet age, there is even more scope for fear to spread like wildfire to set off a market crash - which would of course be limited to 20% in any one day due to circuit breaker rules.
Putting it together, Edwards concludes that "the trigger for the 1987 crash was the fear of US recession caused by the likelihood of US rate rises to stem a hypothetical dollar collapse."
I am clear in my mind both at the time and now, that the US equity market was priced for a continuation of rapid economic and profit growth and this was under threat. The Dow was on nose-bleed valuations, especially as it had ignored the bond sell-off for most of 1997 (was it really 30 years ago that US 10y yields briefly crawled back above 10% - the last time we would see double-digit yields). None of this would have mattered if the US equity market had been cheap. In my view the record 25% ‘Black Monday’ October 19 decline was due to a horrendously expensive equity market suddenly confronted with the fear of recession. Equity valuations matter.
Fast forward to today, when equity valuations matter again; in fact, as Goldman and virtually all other banks agree, company valuations have never been higher. And yet nobody cares, at least none of Edwards' clients. He admits that at this moment, SocGen's clients fear "very little it appears in the near term." Oh, everyone knows stocks are a bubble, but after nearly a decade of crying valuation bubble wolf, so to speak, with no effect whatsoever, "oe thing we hear consistently is that they are not interested in being told equity valuations are expensive. They have been for a while and that does not seem to stop the market going up!"
But, "valuation DOES eventually matter" Edwards writes, as it did 30 years ago, in 1987, when "in the immediate aftermath of the crash, the extreme expense of US equities certainly was clearly a major contributing factor."
So could 1987 happen again, and if so, what would be the catalyst that nobody can see?
The answer to the first, according to Edwards, is that "of course it could. It could happen tomorrow given the extreme expense of US equities and the near universal consensus of a continued acceleration in the economic cycle ? despite the Fed also in the midst of a tightening cycle.As the excellent David Rosenberg of Gluskin Sheff points out, of the13 post war Fed tightening cycles, 10 have ended in unexpected recession."
And, as observed above, one may not even an actual recession, just the fear of one, to start the next 20% plunge: "at these extremes of equity valuation it might not even be an actual recession that produces the next precipitous equity bear market, but the fear of a recession, however misguided that fear may or may not be."
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And yet, as Edwards started off his letter, while "fears" may be pervasive, few clients (or traders, or analysts, or pundits) believe there is a catalyst for a quick and sudden reversal in the market's nearly 9 year momentum is in the immediate future. But is that accurate?
"Is there anything out there that can cause a rapid change in market expectations of future economic growth? Not according to most investors we speak to. But let?s try and think of some things that we maybe need to watch out for."
Here, in addition to the latent overhang of overvaluation, one main concern is "the expectation, or more importantly the fear of more rapid Fed rate rises threatening the economic recovery might be one thing to watch out for." Yet while Janet Yellen's replacement at the Fed will hardly seek to pursue tighter monetary policy, they may have no choice if the recent spike in averae hourly earnings proves to be long-lasting and widespread:
wage inflation has been the dog that didn?t bark this year - or indeed the wolf that didn?t howl. Wage inflation actually slowed this year against the expectations of some naysayer commentators (ie me) of an acceleration (and yes I do mean an acceleration rather than a rise). But it was notable that in the September payroll release, average hourly earnings jumped sharply to 2.9% - a high for this cycle (see chart below).
While many have explained the recent spike in inflation as being a transitory consequence of the two Hurricanes to slam the US this summer, "if for whatever reason it is not an aberration and the Phillips Curve is reasserting itself, similarly high wage inflation data in the months ahead could cause a rapid reappraisal of the pace of Fed rate hikes. At these high equity valuations, that could really scare investors."
Going back to what Deutsche Bank discussed two weeks ago, namely that the Fed is trapped in the 60 bps of space between the short and long end, Edwards writes that any expectation of faster rate hikes will impact the yield curve, which has already been flattening rapidly - a usual prelude to decelerating economic activity. Furthermore, "the dollar is likely to reverse the weakness we have seen since the start of this year, which was in large part a result of an unwinding of ultra long speculative dollar positioning against the euro (as suggested by the CFTC data)."
That has now completely reversed and speculators are very short the dollar. The catalyst for the resumption of the dollar?s rise may have been a sharp recent widening of the US 2y spreads with both Germany and Japan as investors embrace the near certainty of a December US rate hike, but this could go considerably further if investors actually begin to believe the Fed?s own forecasts of future interest rates (ie the Fed dots).
Which brings us to a topic Edwards discussed most recently at the end of August, namely the "Nightmare Scenario" for investors.
The nightmare scenario for equities would be if US wage inflation flickers back to life and investors not only decide that they are too far behind the Fed dots, but they also decide that the Fed itself is behind the tightening curve. In that scenario yields would jump sharply higher across the curve, but especially at the short end and the dollar would soar.
Ironically, as an aside, two weeks ago New River's Eric Peters defined the "Nightmare Scenario" - from the perspective of the next Fed chair - as the opposite: a world in which inflation and wages do not rise, effectively boxing the central bank into continuing to inflate the biggest asset bubble ever leading to a historic crash. To this, we imagine Edwards' response would be that the crash - as is - would be devastating enough.
How to determine if the market is on the verge of said "nightmare scenario" looking at market indicators? "Two critical long-term trend-lines to watch: First our head of technical analysis, Stephanie Aymes, highlights that the breakout point for the 30y downtrend in the dollar against the yen is around Y123/$ (chart left below). Second, as 10y US yields ?smash? above the multi-month support of 2.4%, they can rise all the way to 3% and still be in a bull market (see below)."
Indeed, while many have pointed out the recent breakout in the 10Y above the critical - for the past 6 months - support level of 2.42%, a stronger dollar may be as much, if not more, of a negative factor.
The equity markets? rise this year has been fuelled by profits growth and the expectation of a continuation of the current [weak dollar] trend. Much of that rise in US profits is the direct result of the dollar’s weakness so far this year. Take a look at the two charts below, both comparing US and Japanese profits. On the left, we show forward earnings expectations (TOPIX and S&P500) while on the right we show whole economy profits measures. The key difference is that the stockmarket profits measures have considerably more exposure to overseas earnings and the currency as well as not including smaller and unquoted companies. Hence it is notable that Japanese whole economy profits have considerably outperformed Japanese stockmarket profits, while on the other hand it is startling how US whole economy profits have underperformed US stockmarket profits. I think it?s mainly down to dollar weakness this year.
It's not just nosebleed valuations, rising rates, a spike in the dollar, however: Edwards also brings attention to the bubble in corporate credit markets, or as he puts it, "corporate debt will be the 2007-like vortex of debility in the next downturn. Even the moderate, reasonable, and usually well behind-the-curve, IMF suggests a staggering 20% of US corporates are at risk of default in the next economic downturn." More:
I certainly believe QE has also inflated US corporate debt prices way above what they otherwise should be. Indeed looking at the top left-hand chart, it is clear that typically, the corporate debt market would be in revolt by now in the face of the cyclical debauchment of corporate balance sheets. The fact that both yields and spreads are near all-time lows is, like over-extended equity valuations, a ticking time-bomb waiting to go off. (The chart on the left uses top-down corporate balance sheet data from the Federal Reserve Z1 Flow of Funds book. But the right-hand chart is stockmarket data from Datastream and shows a higher peak recently for quoted stocks, tying up closely with Andrew Lapthorne?s bottom-up analysis. )
There is one last catalyst: China.
Finally a word on China...which does not seem to concern clients at the moment. Incredible when you consider that a little over a year ago China was investors? number one concern. What changed was that the dollar?s weakness this year subdued jitters about renminbi devaluation and the plunge in Chinese reserves.... although on the surface the Chinese economy looks stable, increasingly volatile swings in credit policy are necessary to keep the show on the road ? most apparent in the boom and bust cycle in house prices (see left-hand chart below). A stronger dollar may necessitate another shift towards easy Chinese policy, including a weaker renminbi. That could cause trouble.
And, of course, the overarching factor behind all of the above is the Fedral Reserve. Which brings us to the conclusion:
So a reappraisal in the market?s expectations on the pace of Fed rate hikes, perhaps because of higher than expected wage inflation data, would likely trigger both a rise in yields along the length of a flattening curve and a resumption in the dollar bull market. When the equity market is ridiculously expensive and priced for profits perfection, these events (or indeed as in 1987, the FEAR of these events) could prove catastrophic for QE inflated equity markets.
Which, for those who have followed Edwards' warnings, is in line with his long-running narrative, and which - one day - will prove prescient. For now, however, just do what the algos do and BTFD.